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5 Innovation and technological specialization of Chinese industry and the middle-income trap Keun Lee This chapter is based on a presentation made at the MOR conference held in Hong Kong, early December, 2014, and draws upon Lee and Li (2014) and Lee (2013a). The author thanks comments by the editors of this volume. 5.1 Introduction The middle-income trap (MIT) is a situation in which middle-income countries face a slowdown of growth as they get caught between low-wage manufacturers and highwage innovators because their wage rates are too high to compete with low-wage exporters and the level of their technological capability is too low to enable them to compete with advanced countries (Lin 2012; Williamson 2012; World Bank 2010 and 2012; Yusuf and Nabeshima 2009). The risk of the MIT is not limited to the selected countries but is relevant to many countries in the world. The China Report by the World Bank (2012) compares the income levels of several countries (compared with that of the United States) in 1960 with those in 2008. This analysis reveals that at least thirty countries have fallen into the MIT. Specifically, income growth is more significantly slowed in upper middle-income countries or in countries with an income level of 20% to 30% of that of the United States. 1 As China increases its economic growth, reaching around 30% of the per capita income of the United States, it faces the possibility of the so-called middle-income trap, similar to other middle-income developing economies (Lee 2013a). Several countries have attained middle-income status but have subsequently failed to achieve highincome status. Examples from Latin America include Brazil and Argentina, whose growth stalled in the 1980s and 1990s, respectively (Lee and Kim 2009, table 1). There can be many criteria upon which to judge the possibility of the MIT, and the difficulty is identifying the effective criteria for the assessment. Thus, being agnostic about the causes of the MIT, Aiyar et al. (2013) consider as broad a range of factors as possible, such as demographic conditions; institutions; and industry and trade structures, including diversification, physical infrastructure, and macro-financial developments. They test whether each of these is particularly binding for middleincome countries. On the one hand, the literature finds political institution variables, such as democracy and the rule of law, important for economic growth in general or in low-income countries but insignificant in middle-income countries (Aiyar et al. 2013; Huang, Qin, and Xun 2013; Lee and Kim 2009). On the other hand, physical infrastructure or investment is significant for economic growth in middle-income countries (Aiyar et al. 2013), but China has been investing heavily in this infrastructure and can be considered free from shortage of such. Thus, physical infrastructure would not be an interesting or meaningful criterion to assess the MIT in China. This study will use innovation as the criterion to assess the possibility of the MIT in China. Innovation is a significant factor for economic growth in middle-income countries and particularly relevant for China, but mixed evidence exists that China has already overcome this constraint or not (Eichengreen, Park, and Shin 2013; Jin and Lee 2 2013; Lee 2013a; Lee and Kim 2009; Lee et al. 2013; Sylwester 2000). In particular, this study pays attention of the emerging pattern of technological specialization in China, and it addresses the question of whether China is also moving into short-cycle technology-based sectors, which have been the leading sectors of the past catch-up in Korea or Taiwan (Lee 2013a). The next section discusses further why innovation can be a good criterion to discuss the MIT issue. Then, Sections 5.3 and 5.4 discuss innovation capability and technological specialization of Chinese industry, respectively. Section 5.5 concludes. 5.2 Why innovation as the criterion to assess possibility of the MIT in China This criterion of innovation is most consistent with the original concern expressed by the term MIT, because numerous studies consider it to occur as middle-income countries get caught between low-wage manufacturers and high-wage innovators because their wage rates are too high to compete with low-wage exporters and their level of technological capability is too low to enable them to compete with advanced countries (Lin 2012; Williamson 2012; World Bank 2010 and 2012; Yusuf and Nabeshima 2009). In other words, the MIT phenomenon is a problem of growth slowdown because of weak innovation. Also, when countries are divided into income groups, only innovation and higher education matter for upper middle- and high-income countries, whereas political institutions and primary and secondary education matter for low- and lower middleincome countries (Lee and Kim 2009). Eichengreen, Park, and Shin (2013) also find human capital and innovation important, especially tertiary education, for upper 3 middle-income countries. Given that China is already an upper middle-income country, those criteria of higher education and innovation make sense for China. A World Bank (2005: 11) assessment of the reform decade of the 1990s also observes that growth-oriented actions, such as technological catch-up and the encouragement of risk taking, may be needed for faster accumulation and recognizes technological innovation as one of the most serious bottlenecks of growth in many countries, especially in the middle-income countries of Latin America. Lee and Mathews (2010) also compare the East Asian experience with the elements of the Washington Consensus to argue that the mixed results of the consensus are related to missing or neglected policies, such as technological policies and revolutions in higher education. R&D to GDP ratio is one simple criterion to look at countries’ innovation capabilities. Although one might expect a positive correlation between income levels and the R&D–GDP ratio, the ratio suddenly becomes flat among middle-income countries (Lee 2013b), or countries with per capita income between USD 1,000 and USD 10,000. In other words, the ratio does not increase proportionally with per capita income in this group of countries, suggesting that the flat relationship is a root cause of the MIT, as noted in Lee (2013a) by the same graph. A similar conclusion can be derived by examining the number of U.S. patents filed by countries. In the early 1980s, when the income level of Korea was similar to those of Brazil and Argentina, the number of U.S. patent applications by Koreans was approximately fifty, within the range of other middle-income countries, such as Brazil and Argentina (Lee and Kim 2009; table 1). In the 1980s and 1990s, Korean applications increased rapidly to more than ten times the average of other middleincome countries where incomes remained relatively flat. In 2000, Korea and Taiwan 4 filed approximately 5,000 U.S. patent applications, whereas other middle- or lowerincome countries, including Brazil and Argentina, filed less than 500 per year (Lee and Kim 2009). In other words, the difference between the more successful Asian economies and the less successful Latin American economies (or the reversal of fortune between these two groups of countries) can be explained by the amount of priority given to the enhancement of long-term growth potentials, particularly innovation capability (Lee 2013a; Lee and Kim 2009). 5.3 Innovation capability of China As stated in the preceding sections, one criterion in assessing the ability of a country to move beyond the MIT is whether the country is sufficiently innovative to achieve a certain level of technological capability backed up by an adequate emphasis on higher or tertiary education. In general, our answer to this question is that China appears to be performing well. In this regard, literature has already noted several unique features of Chinese industry and firms in building technological capabilities and promoting industrial development. Lee et al. (Lee, Jee, and Eun 2011; Lee et al. 2013) note that unique Chinese features include the following three elements: (1) parallel learning from foreign direct investment (FDI) firms to promote indigenous companies; (2) an emphasis on “forward engineering” (the function of university spin-off firms) in contrast to the reverse engineering of Korea and Taiwan; (3) the acquisition of technology and brands via international mergers and acquisitions. These three elements may be regarded as comprising the Beijing model because they have not been explicitly adopted by Korea and Taiwan (Lee, Jee, and Eun 2011). 5 Although the above is a qualitative account of China’s success in technological learning and upgrading, many quantitative indications are also available as discussed in what follows. First, we can consider the ratio of R&D to GDP, a basic measure of the innovation efforts of a country. Lee (2010) observes that China has strongly been pushing for considerable R&D expenditure and thus surpassed the 1% threshold ratio of R&D to GDP in 2000, earlier than the majority of middle-income countries in Latin America did. The spending of China on R&D as a percentage of GDP, known as R&D intensity, has more than doubled from 0.6% in 1995 to over 1.3% in 2003. This increase has accelerated since the 2000s and is now close to 2.0%. Actually, China is an outlier among middle-income countries with a high ratio of R&D to GDP. Because of this massive investment in R&D, China has rapidly increased its flow of patents. The average growth rate of domestic invention patenting has increased, from approximately 17% in the earlier period to approximately 49% in the later period (Lee 2010, table 4), with approximately 5,000 patents registered in early 2000 to more than 20,000 in the late 2000s. The number of patent applications abroad (particularly in the United States) has also increased. The number of U.S. patents filed by China reached more than 2,500 in 2010, greater than that of U.S. patents filed by other middle-income countries (less than 300 patents per year) (Table 5.1). In terms of the growth rate of patents, China ranked first in the world in the 2000s, whereas Korea dominated in the 1990s. Begin Table 5.1 Table 5.1 U.S. patents granted to selected countries (1981–2010) Country 1981 1985 1990 1995 2000 2005 2008 2009 2010 USA 39,218 39,556 47,391 55,739 85,068 74,637 77,502 82,382 107,792 6 Japan 8,389 12,746 19,525 21,764 31,295 30,341 33,682 35,501 44,814 Germany 6,304 6,718 7,614 6,600 10,235 9,011 8,914 9,000 12,363 Taiwan 80 174 732 1,620 4,667 5,118 6,339 6,642 8,238 Korea 17 41 225 1,161 3,314 4,352 7,548 8,762 11,671 China 2 1 47 62 119 402 1,225 1,655 2,657 India 6 10 23 37 131 384 634 679 1,098 Brazil 23 30 41 63 98 77 101 103 175 Malaysia 1 3 3 7 42 88 152 158 202 Source: The United States Patent and Trademark Office(USPTO). Table 8.3 of Lee, 2013a. End Table 5.1 Another important comparative criterion is whether China measures up to the three important yardsticks of technological catch-up (Lee and Kim 2010) followed by Japan, Korea, and Taiwan in the past: (a) whether resident patenting catches up with nonresident patenting in a host country, (b) whether regular invention patents catch up with utility model patents (petite patents), and (c) whether corporate patenting catches up with individual inventor patenting. Lee (2010) highlights that all these three patterns of catch-up were observed in China in the mid 2000s. In terms of the number of patent applications in China, the share of domestic inventors outgrew that of foreigners in 2003, with domestic inventors filing more than 50,000 applications. In 2004, the number of regular invention patents exceeded that of utility model patents. In 2007, the number of patent applications by corporations exceeded that of applications by individual inventors, signifying the growing importance of corporate innovation. While these are achievements in terms of domestic patents filed in China, the vast bulk of Chinese USPTO patents are owned by foreign firms, which should be the area China must try to improve. 7 5.4 Technological specialization in China As the last but probably the most important indicator of the technological strength of China, let us turn to technological specialization. According to Lee (2013a), technological specialization matters more for countries at the middle-income stage, whereas the traditional trade-based specialization, following the resource-based factor intensity, is relevant from the low- to the middle-income stage. Technological specialization can be measured by the cycle time of technologies shown by patent portfolio of countries (Lee 2013a). “Cycle time” refers to the speed with which technologies change or become obsolete over time and the speed and frequency at which new technologies emerge (Lee 2013a; Park and Lee 2006). A technology-based sector with short cycle time relies less on existing technologies and can thus leverage the great opportunities brought by new technologies. Lee (2013a) argues that qualified latecomers have great advantages in targeting technological sectors with short cycle time and specializing in these sectors because a short cycle of technologies implies that dominance by the incumbent is often disrupted and that new technologies always present new opportunities. Minimal reliance on existing technologies indicates low entry barriers and high profitability associated with few collisions with the technologies of advanced countries, minimal royalty payments, and even first- or fast-mover advantages or product differentiation (Lee 2013a).1 Thus, combined with the new structural economics idea of the “growth identification and facilitation” framework of Lin (Chapter 2 in this volume; 2012), the Of course, other aspects of the technological regime must also be considered; for example, while corporate software is a short-cycle technology, it corresponds to a higher degree of network effects and cumulativeness which make it difficult to enter for latecomer firms. 1 8 idea of technological specialization may provide a comprehensive policy framework for economic growth of developing countries. Lin (Chapter 2 in this volume) advises latecomers to closely observe the countries slightly ahead of them, and then to target the mature industries in those countries as their latent comparative advantages. While such recommendations are an effective and practical guide for sectoral targeting for those developing countries, in particular at lower-income stages, this, a more theoretical, argument for technology-based specialization works better for upper middle-income countries. In other words, after a developing country makes some success with inheriting mature sectors from countries above them, it may then be advised also to try to enter sectors based on shorter-cycle technology or even to take the risk of leapfrogging into new or emerging sectors. Of course, the whole process should be a gradual movement into shorter-cycle sectors involving multiple stages. So, the point is that sustained catching-up growth requires not only an entrance into mature industries (which are still new to the latecomers), but also leapfrogging into emerging industries that are new to both the advanced and developing countries. Technological development in Korea (Lee 2013a) shows the increasing specialization of Korean industries based on short cycle time. The Korean economy began with labor-intensive (long-cycle technology) industries, such as apparel or shoe industries, in the 1960s. The economy then moved toward the short- or medium-cycle sectors of low-end consumer electronics and automobile assemblies in the 1970s and 1980s and then even further to the shorter-cycle sectors of telecommunication equipment (telephone switches) since the late 1980s, and then memory chips, cell phones, and digital TVs in the 1990s. Korean industries have kept moving into shortercycle technologies and have thus achieved technological diversification. 9 Figure 5.1 shows the actual trends in the cycle time of technologies as calculated following U.S. patents jointly held by Korea and Taiwan and those held by China. The numbers in the vertical axis represent the average cycle time of patents held by the economies, defined by Jaffe and Trajtenberg (2002) as the mean backward citation lags, namely, the time difference between the application or grant year of the citing patent and that of the cited patents. For example, a value of eight on the vertical axis indicates that the average cycle time of patents is eight years, indicating, for instance, that Korea and Taiwan jointly cite eight-year-old patents on average. Since the mid 1980s, both catching-up economies have traveled in a path toward technologies with an increasingly short cycle time. Thus, the average cycle time of the patents held by Korea and Taiwan became shorter, reaching six to seven years by the late 1990s. This duration is two to three years shorter than the average cycle time of the patents held by European G5 countries whose cycle time has ranged from nine to ten years since the late 1980s. Consequently, Korea and Taiwan have a completely different patent portfolio from those of other advanced countries (Lee 2013a). Therefore, we consider the mid 1980s as an important turning point that opened a path for sustained catch-up beyond the middle-income stage. In this period, Taiwan and Korea reached the middle-income level: the per capita GDP of Korea became 25% of that of the United States, and Korea and Taiwan increased their R&D expenditure, with their R&D–GDP ratio averaging more than 1% annually. Thus, when these countries decisively began the journey toward more technology-based growth, the cycle time of their technologies moved in progressively shorter directions, such as various IT products. However, after they achieved technological catch-up, the next stage for maturing of specialization should occur. Actually, Figure 5.1 shows that only in the 2000s, when 10 Korea and Taiwan became more mature economies, their technologies turned in the opposite direction toward long cycles. Lee (2013a) refers to this strategy of technological specialization in short-cycle technologies during the catching-up period as a “detour” because developing countries do not directly and immediately replicate the path and industries of advanced economies that specialize in long-cycle technologies. Instead, countries that are successful at catching up have moved initially in the opposite direction progressively toward a sector with short-cycle technologies. However, as the countries reach the point of technological maturity (as many did in the early 2000s), their success enables them to adopt long-cycle technologies, such as biomedical or pharmaceutical industries. Begin Figure 5.1 Figure 5.1 Cycle time of technology shown in U.S. patents by China and Korea/Taiwan Source: Author’s calculation according to method used by Lee, 2013a. End Figure 5.1 11 Therefore, an interesting measure of the prospects of a country beyond the middle-income stage is whether it has reached such a “technological turning point” and has switched from long cycles to short ones along the curve of the cycle time of technologies. Figure 5.1, based on Lee (2013a), shows that China passed such a turning point in the middle to late 1990s, approximately ten to fifteen years later than Korea. The top thirty technologies in the U.S. patents of China (Lee 2013a, table 8.4) are similar to those of Korea and Taiwan from 1980 to 1995. The Chinese hold several patents for semiconductors, information storage, telecommunications, electrical lighting, electrical heating, X-rays, and computer hardware and software. The weighted average cycle time of Chinese technology from 2000 to 2005 was 8.07 years, closer to the Korean/Taiwanese average of 7.69 from 1980 to 1995 than to the Brazilian/Argentinean average of 9.26 in the same period (Lee 2013a). In sum, the short cycle time of technologies of the U.S. patents held by China and its turning point in the late 1990s can be regarded as additional evidence of the progress of the country in terms of innovation. Jin, Lee, and Kim (2008) and Jin and Lee (2013) also show that the growth engines of China have shifted from FDI, denationalization, and exports to innovation and exports. Cross-province regressions reveal that whereas exports, FDI, and the reduction of the state sector were the important growth engines during the early period, knowledge and innovation have become more important in the recent period and that, among traditional policy variables, shares in exports remain significant, but shares in foreign capital and state ownership have been insignificant to economic growth. 12 5.5 Concluding remarks This chapter discusses the possibility of China falling into the so-called MIT in terms of innovation capability, especially its technological specialization into short- or long-cycle sectors. The conclusion is that China has increasingly become innovative and thus differs from other middle-income countries. So, China is not likely to be falling into the MIT at least from the innovation point of view. In terms of technological specialization, China has already passed the “technological turning point” by increasingly moving into short-cycle technology-based sectors. Lee (2013a) shows that China passed such a turning point in the middle to late 1990s, approximately ten to fifteen years later than Korea or Taiwan. The next issue will be when China will pass the second technological turning point of moving back into the long-cycle technology-based sectors. In the case of smaller economies, like Korea, this second turning point came in the early 2000s. One can expect a giant economy like China to show a more balanced pattern of specialization at an earlier stage or in a shorter period of time after the first turning point. Verification of this conjecture can be done by updating the trend of the average cycle time using the more recent portfolio of the Chinese-held patents. If one can find a new trend that the average cycle time of the Chinese-owned patents are getting longer, for instance, by the increase of patents in biomedical industries, that may be a signal of the arrival of the second turning point of China’s technological specialization. There are some signs that this is happening actually, as we are now witnessing the rise of successful companies in diverse fields, including Beijing Genomics Institute(BGI) in biotechnologies. Given that long-cycle sectors may require a longer time to achieve some results, different policy 13 approaches, different from the traditional supply-side-oriented targeting, may be needed. This issue can be a topic for future research. chapter-references References Aiyar, Shekhar, Romain Duval, Damien Puy, Yiqun Wu, Longmei Zhang (2013). Growth Slowdowns and the Middle-Income Trap. IMF Working Paper, 71. Washington, DC: IMF. Eichengreen, Barry, Donghyun Park, Kwanho Shin (2013). 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